Why I Write This Blog (Part 2)

5a) As I hoped you all deduced from yesterdays blog: if we do not take risk in our investments (i.e. we stick our money in a savings account, GIC or T-bill), we will not be able to stay ahead of the annual increase in our cost of living and definitely increase the possibility that we might run out of money before we run out of life. Nobody wants that to happen.

5b) If we give our money to a bank or financial institution mutual fund salesperson who calls him / herself a financial advisor, the lack of fiduciary responsibility and cost of doing so is not necessarily providing you with safety. In fact the fees and costs combined with the lack of fiduciary responsibility increase the risk that you will not be able to meet your goals. That is bad risk.

5c) We know that we have to take risk, but we want to take good, calculated risk. Not bad risk.

6) As portfolio managers, we specialize in finding good risk for the purposes of investing, over the long-term: getting the best possible risk-adjusted average annual compound returns over multiple years. I want you all to take a good close look at the table and chart above: the 5 year Total Return Data for a number of investment vehicles.

7) First and foremost, all of our data (in the above chart) is historical. We (at High Rock) nor anybody else for that matter can accurately predict the future. Some people say that they can, if they tell you that, run away and run away fast, because they have an agenda to sell you something and they will use it to persuade you of buy into their scheme. That is why the regulators require us to provide the disclaimer: "past performance is not a guarantee of future returns".

8) However, we also know that all things economic and financial are cyclical, so there may be some message buried in the historical data. So we do an enormous amount of research to determine, historically, what kind of risk each investment we purchase for our and our client portfolios has posed. In the above chart, the vertical axis is return (compound annual average return on a monthly basis), the horizontal axis is risk (as measured by the standard deviations of those monthly returns) the lowest being zero, the highest on the chart being 12. That is the proverbial return vs. risk equation that we financial geeks all talk about in broad terms. We go beyond the broad terms and determine how each investment sits on that particular chart. 

It would be difficult to put any individual company stocks on the chart above because even some of the best companies have more risk than the 12 that is the highest level of risk displayed. We all talk about diversity of investments because owning just one company's stock (all your eggs in one basket) would give you way too much risk (off the scale). If you owned all the stocks in the S&P 500 (which is equivalent to owning all 500 companies and plenty of diversity across economic sectors), you would have a risk level of 10.9 (blue diamond on the chart) that has returned 8.45% annual average compound return over the last 5 years. Which means that while historically, the return has been good, the potential downside (of 1 standard deviation) is close to 11%, which could easily wipe out any gains in a given year. That is still a lot of risk to have, considering that recent volatility has produced swings of more than 1 standard deviation.

9) So depending on our long-term goals we have to consider this in our portfolio mix. Optimally, we want the combination of all of our investments to reside inside that blue box in the north-east quadrant where the best return per unit of risk resides. And that is what we work so hard to do at High Rock for our and our client portfolios.

More tomorrow.